Tax Reform and equities: the long and always winding road
While it’s too soon to hold ones breathe in anticipation of the latest tax reform proposal, equity investors should be mindful of the rhetoric through mid-term elections next year.
Recently, Republican leaders released an outline of their much anticipated tax plan, which is called “Unified Framework for Fixing Our Broken Tax Code.” Shortly afterward, Senate Budget Committee released its 2018 Budget Resolution to be voted in the next few weeks. Combined, these two agendas are key Republican priorities ahead of 2018 mid-term elections. With that said, we look at the timing and procedure, financial impacting of major tax proposals, and sectors that will likely benefit from the passage of US tax reform.
Timing and procedure
Under the Budget Enforcement Act of 1990, any tax reform must not add to the federal debt. Thus any loss in tax revenue need to be offset by reduced benefits or spending cuts. With the pressure of pushing through this key legislation, Senate Budget Committee members Senator Pat Toomey (R-PA) and Senator Bob Corker (R-TN) reached an agreement that allow any tax legislation to not increase the deficit by more than $1.5 trillion over 10 years.
Below are the major timelines if the legislation progress as scheduled.
- The House passed the 2018 Budget Resolution last Thursday (October 5th) with 219 votes. The Senate Budget Committee is expected to mark up and vote on their version over the next few weeks. The two chambers will then have to reconcile and agreed to the different versions of the Budget Resolution before the Thanksgiving holiday. The passing of 2018 budget will increase the likelihood of Tax Reform legislation given the reconciliation process and general agreement on the fiscal framework.
- After the passing the 2018 Budget Resolution, the House Ways and Means Committee and the Senate Financing Committee will have 45 days to mock up the tax legislation.
- The full House and Senate will separately debate and vote on the tax reform legislation.
- Tax plan is expected to be signed by the President in the first half 2018 with final implementation in 2019.
With mid-term elections looming in November 2018, there is considerable pressure for Republicans to push through this major piece of tax legislation. Earlier this month, KPMG conducted a survey among finance executives and estimate ~ 67% probability of legislation passing in 2018-19 timeframe.1
Key tax reform proposals
The Tax Policy Center estimates that the tax reform will be approximately $2.6 trillion of benefit for corporations over the next 10 years.2
There are four key proposals within this legislature that we expect will impact corporations:
- Tax rate of 20% could result in corporate tax savings of $1.9 trillion over the next 10 years.
- Incentives for capital project spending. Allowing equipment expensing, rather than capitalizing, will result in lower income and thus lower tax payment over the next few years. This would result in approximately $500 billion in tax savings over the next 10 years.
- Repatriation at a one-time 10% rate. Companies are able to repatriate foreign earnings one-time at 10%. While this has no tax savings impact, companies are allowed to bring back overseas cash at lower tax burden to be used for share repurchase and investments.
- Pass-through rates to 25% from 39.6%. Corporations owning a pass-through entity will have income taxed at a lower rate, resulting in $400 billion in tax savings over 10 years.
While tax legislation will benefit most corporations, particularly those with higher domestic sales in the United States, there are two sectors that will be clear winners under the plan.
We highlight the benefits that will accrue to the technology and industrial sectors.
- Technology. S&P 500 companies have approximately $1 trillion of cash held overseas, with technology companies holding more than $600 billion of the untaxed cash overseas.3 After the passage of Homeland Investment Act in 2004, corporations repatriated over $300 billions of cash, which resulted in large increases in buyback and internal investment in the following years. This time around, we see companies taking similar actions under the new repatriation scheme.
- Industrials and transports. We think Industrial companies will benefit through the higher sales from capital equipment investment incentive. Furthermore, the incremental sales will be taxed at a lower rate. Transport companies are primarily US domiciled and will be beneficiaries of higher business activities and lower tax rates. For example, companies such as Southwest and Federal Express currently pays 36% and 35% tax rate, respectively.
In summary, we believe tax reform will unevenly benefit US-based corporations and could provide more than $10 EPS lift to S&P 500 earnings. At current multiple, this translates to approximately 150 points to the index.2 Of course, earnings growth is not always indicative of future stock performance, and tax reform is very difficult to pass and will likely require support from Democrats. To put it into perspective, the last time US Tax Code was overhauled was 30 years ago (1986) and it took more than 13 months of bipartisan support for the legislation to pass. As of now, it remains to be seen if politicians can reach across the aisle to gain sufficient support for tax reform.
1 KPMG TaxWatch. September 7, 2017
2 Tax Policy Center
3 Goldman Portfolio Strategy. September 25, 2017
4 JP Morgan US Strategy. September 15, 2017
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.